Monday, April 1, 2019

Indian IT Services: 4QFY19 Preview: Some Strength, Some Sluggishness

We expect a steady quarter with strong growth from Infosys, TCS and HCLT and muted growth for Wipro and Tech Mahindra. Benefit from strong deal flow and increasing digital deal sizes will be offset to some extent with slower spending growth in budgets in FY2020. We expect broadly similar industry growth in FY2020E. Profitability will face the test of increasing cost onsite. We expect Infosys, HCLT and Tech Mahindra to grow faster in FY2020E. Stock returns can be muted from here after a strong performance in the past 12 months.

Expect steady growth for key Tier-1 companies

We expect constant currency revenue growth rate at 1.8-2.5% for Infosys, TCS and HCLT. On yoy comparison, revenue growth will be robust 10.8-13.8% for the three companies. Growth will be led by ramp-up of large deals won by companies over the past two quarters. All companies reported strong deal flow in the December 2018 quarter. Tech Mahindra will likely report muted numbers due to seasonal weakness in retail and a slower manufacturing vertical. Wipro will likely report modest 1.5% sequential revenue growth. Revenue growth for mid-tier companies will be muted on sequential basis when compared to the trend same time last year. We note that March is a seasonally weak quarter for IT companies. Depreciation of GBP against USD will likely create cross-currency tailwind of 0-60 bps for our coverage universe.

EBIT margin—multiple headwinds for different companies

Despite currency depreciation, EBIT margin for three of the five Tier-1 companies will be flat or decline on yoy comparison. Infosys, Tech Mahindra and Wipro will report marginal sequential decline in EBIT margin. On sequential basis, EBIT margin will decline marginally due to 1.9% appreciation of the INR against USD and talent constraint-led increase in cost structure in the US. Profitability performance will be a key focus area.

FY2020E revenue growth guidance—8-10% revenue growth for Infosys and 14-16% for HCLT

We expect healthy revenue growth guidance of 8-10% for Infosys in FY2020E. This would imply revenue CQGR of 1.7-2.4% in four quarters of FY2020E. Strong revenue growth outlook will be courtesy large deal momentum, increase in win rates, investments in S&M and gains in a few consolidation decisions. We note that our guidance expectation includes a small component of inorganic element. Infosys’ intent is to defend 22-24% EBIT margin band though that will be tested against the reality of margin headwinds and a weak FY2019 exit trajectory. We believe that Infosys’ EBIT margin will be closer to 22% in FY2020E. We expect HCLT to guide for 7-9% organic c/c revenue growth rate, 8.5-10.5% including inorganic component but excluding IBM’s product acquisitions and 14-16% including IBM’s product business acquisition assuming it gets consolidated from July 2019. We expect the company to retain 19.5-20.5% EBIT margin guidance band. Despite a weak quarter, TM is unlikely to change FY2020E growth outlook.

Demand from the banking vertical will be a focus area

Banking is the largest vertical for IT companies. At a broader level, spending growth in the vertical will be slower than CY2018. We believe that IT spending will be muted in the capital markets segments, especially in Europe. We expect steady spending in the traditional banking segment in North America though there may be spending caution from a couple of large clients. Growth for individual player will be a function of exposure to sub-segments of the banking vertical and share gains/losses in consolidation decisions. We expect slower growth from this vertical for the industry in FY2020E.

Profitability dynamics will be another key focus area

Challenges in renewal of visas combined with tightening of conditions for new visas come at a time when the unemployment rates are at a record low. Even as IT companies have stepped up local hiring, the fact is that talent is not easily available at the mid-level. This will lead to increase in cost structure in the US. The increase in cost structure was already visible in December 2018 quarter where subcontracting costs increased for Infosys and TCS. Some amount of rupee depreciation is necessary to offset the cost increase.

Attractiveness of the sector has reduced post strong performance

The IT sector has performed well in the past 12 months on the back of currency tailwinds and demand acceleration. Many stocks are trading at peak cycle multiple and bake in elevated revenue growth and sustenance of profitability. This leaves little on the table to generate returns. We expect muted stock returns. HCLT’s stock price underperformance and strong deal momentum make it an attractive play. We retain ADD rating on the stock. Tech Mahindra theme has more legs, likely weak 4QFY19 notwithstanding. The stock trades at inexpensive valuations. We maintain ADD rating. Infosys has near-term earnings risk. The turnaround has progressed well with likely return to top quartile of performance on growth. We like the Infosys story but would wait for a better entry price.

Comments on individual companies

* Infosys. We expect constant currency revenue growth of 1.9% and cross-currency tailwind of 30 bps. 3Q is a seasonally weak quarter, yet we expect robust growth powered by large deal ramp-up in telecom and other verticals. On profitability we expect EBIT margin to decline further due to costs associated with large deal ramp-up, retention bonuses and investments to accelerate growth. We note that 3QFY19 margin had a one-off impact of 40 bps from declassification of Panaya and Skava from assets held for sale. Progress on catch-up with competition on digital competencies will be keenly tracked. The company has made solid progress in large deal signings and seems to be taking steps in turning around the consulting business through high-profile hires from competition. We expect Infosys to guide for 8-10% revenue growth in constant currency for FY2020E. Infosys has intent to defend EBIT margin band of 22-24% though this will be tested against the backdrop of a poor exit margin of 22%. We believe that Infosys' EBIT margin could decline by 100 bps in FY2020E. Finally we expect investor focus on (1) TCV of deal wins that has started looking up, (2) attrition rate direction where the company has made a number of interventions to bring it down, (3) progress in service lines where the company trails competition, viz. BPO and IMS and (4) pricing outlook, especially in light of fears that the company has focused on growth at any cost approach.

* TCS. We expect constant currency (c/c) revenue growth of 1.8% and cross-currency tailwind of 60 bps. We expect stable margins; impact of rupee appreciation will be offset by tightening of operations. Net profit growth is an impressive 22% led by acceleration in growth and currency tailwind. We have not assumed any Fx gain in the quarter as compared to Rs4.59 bn in December 2018 quarter resulting in a sequential net profit decline. TCS has large exposure to the banking vertical. Outcome of the budgeting process and consequent impact on spending will be a key focus area. We expect investor focus on (1) outcome of budgeting process, especially in financial services, (2) pipeline of large deals, (3) whether the company can deliver double-digit growth without the support of mega-deals, and (4) EBIT margin outlook against the backdrop of talent constraint in the US.

* Wipro. We expect constant currency revenue growth rate of 1.5% and cross-currency tailwind of 40 bps. Financial services growth rate could moderate from the recent quarter growth of 17% yoy. Spending outlook in financial services is a lot more muted than same time last year. We expect EBIT margin decline of 30 bps on sequential basis courtesy rupee appreciation, alignment of entry-level compensation and headwind from insolvency of a telecom client. We expect Wipro to guide to 0.5-2.5% revenue growth for June 2019 quarter. June is a seasonally weak quarter for the company. We expect investor focus on (1) outlook for the key growth driver, viz. financial services vertical, (2) sustainability of margin, (3) state of demand from healthcare vertical, (4) capital allocation and the quantum of buyback and (5) performance of acquired entities.

* HCLT. We expect constant currency revenue growth of 2.5% and cross-currency tailwind of 20 bps. We expect revenue growth to be led by the IMS segment courtesy ramp-up of large deals. We expect EBIT margin to decline by 10 bps courtesy rupee appreciation and elevated investments in the business. We expect the company to guide for 14-16% revenue growth of which will include an inorganic component of 5.4% revenues from the IBM products buyout. Excluding revenues from IBM products but including revenues from other inorganic components, we expect HCLT to guide for 8.5-10.5% revenue growth. We expect HCLT to guide for stable margins in FY2020E. Deal momentum has been extremely strong with announcement of several large and mega deals. We expect front-ended revenue growth. We expect investor focus on (1) capital allocation in light of aggressive product acquisitions, (2) M&A strategy given that the company has started making a few digital acquisitions, (3) efforts to broad-base revenue growth beyond IMS and (4) deflationary impact from renewal of legacy IMS deals.

* Tech Mahindra. We expect constant currency revenue growth of 1% and cross-currency tailwind of 50 bps. Revenue growth will be led by communications vertical. We expect flattish revenues in the enterprise segment on account of lower revenues in retail and high December 2018 quarter base impact in the manufacturing vertical. EBIT margin will decline due to rupee depreciation and spike in depreciation charge. We expect marginal forex gain as compared to forex loss of Rs779 mn in December 2018 quarter. Expect strong TCV of new bookings. TCV will be higher than the usual US$275-325 mn range. We expect investors to focus on (1) demand outlook, especially for telecom vertical and the timelines where 5G deals will start flowing, (2) health of enterprise business, especially in the manufacturing vertical where the company has high exposure to auto sector, (3) attrition trend and (4) M&A strategy and capital allocation.

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